Academic journal article Journal of Money, Credit & Banking

Valuing the Futures Market Clearinghouse's Default Exposure during the 1987 Crash

Academic journal article Journal of Money, Credit & Banking

Valuing the Futures Market Clearinghouse's Default Exposure during the 1987 Crash

Article excerpt

Futures and forward contracts are agreements between two parties to buy or sell an asset at a future date at a price set today. Futures contracts, unlike forward contracts, trade on organized exchanges. Futures market clearinghouses are intermediaries that make large-volume trading between anonymous parties feasible by guaranteeing performance on all trades between clearing members. Nonmembers execute trades through a clearing member. Clearinghouse intermediation makes futures contracts liquid and isolates traders from individual counterparty default risk.(1)

The margin system is the clearinghouse's first line of defense against default risk. Margin collection and administration are organized in a pyramid structure described in Edwards (1983). The clearinghouse, at the top of the pyramid, collects margins from clearing members. The clearinghouse demands a performance bond (initial margin) when a contract is opened. Thereafter, the clearinghouse "marks" member accounts "to market" to prevent losses from accumulating. It collects funds (variation margin) from clearing members who hold contracts that had a capital loss and distributes funds (also called variation margin) to members who hold contracts that had a capital gain. Clearing member futures commission merchants (FCMs) collect margins from (and distribute gains to) nonclearing FCMs who execute their trades through the clearing member. At the base of the pyramid all FCMs collect margins from and distribute gains to their customers. If the losers don't meet the variation margin call, then the clearinghouse must come up with the funds from its own reserves, or assess the remaining solvent clearing members, or default.

On Monday, October 19, 1987, the S&P 500 futures price declined by 29 percent--the largest one-day price change since trading began. On that day the Chicago Mercantile Exchange (CME) clearinghouse issued variation margin calls for a record $2.5 billion. The Commodity Futures Trading Commission (the regulatory board for the futures markets) disclosed that during October fourteen FCMs became undersegregated (the FCM had less than the required cash in consumer accounts) and three firms were undercapitalized. In addition eleven firms, including six CME members, had margin calls to a single customer that exceeded their capital. Traders feared that a default by a large customer would trigger a cascade collapsing the pyramid. Rumors spread that a major clearinghouse might fail.(2)

The clearinghouse's default exposure depends on the probability distribution of changes in the futures price. The traditional measure of risk is the probability that a price change will exceed the margin. Figlewski (1984), Gay, Hunter, and Kolb (1986), Hsieh (1993), Kupiec (1994), and others estimate the tail probabilities. However, this measure is somewhat limited in ignoring the consequences of a futures price move that exhausts posted margin. We present two additional methods of assessing clearinghouse exposure, and use them along with tail probability estimates to examine the CME's exposure in late 1987 on the popular S&P 500 futures contract.

The first additional measure of default exposure is the expected value of the additional funds required to ensure performance on all futures contracts. If evaluated using asset-pricing techniques, this expectation is the premium a clearinghouse would pay for a hypothetical insurance policy that would cover the additional funds. As in some previous examinations of default risk, pricing this insurance draws upon option theory.(3)

Second, we estimate the expected additional funds requirement conditional on a futures move exhausting the posted margin. Conceptually, this is the expected amount that must be met by other resources: the remaining assets of losing customers, the assets of the clearinghouse and FCMs, potentially even the willingness of the central bank to intervene. To our knowledge, this measure has not been previously used in examining clearinghouse exposure. …

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